Understanding the Risks of VC Signaling

I recently wrote a blog post on understanding how the size and age of a venture capital fund might affect you when you’re raising money. Because it is a “series” I plan to get into some of the deeper complexities of funds such as “cross over funds” and “why VC’s hate to price their own deals” at a later stage. The last post was a high-level primer. I know many super experienced entrepreneurs who don’t understand the basics of how fund size and age can affect them so I thought it was worth establishing a baseline.

But I understand Chris’s sentiment and in certain situations I agree. But while he’s directionally right that there are risks, he’s wrong to rule out all VC’s who do seed investing. Yes, I’m a VC who does seed investing so I have a bias. But Chris is a seed investor who competes for deals with VCs so the bias runs both ways. I bet if we discussed the issue live we’d probably end up agreeing more than disagreeing.

Let me elaborate:

1. The problem with VC Seed Funding – Chris is right to raise the issue with entrepreneurs because there have been instances where large VC funds have set up seed programs where the investments have been used as “options.” There are many problems with this. First, if the VC does 15-20 of these under one partner then it is certain he can’t spend any time with these investments. And they don’t. I believe these VC funds have suffered some amount of reputation fall out. In a world of The Funded, VentureHacks and entrepreneur blogs this kind of information spreads like wildfire.

Second, more damning is the “signaling problem.” This means that if a VC invests in your seed round and does not participate in a future round the next round investor will think to himself, “well, if Big VC Co. invested in the seed round they have more inside knowledge than I do. If they’re not willing to fund the next round then something must be wrong with this company.” This is true and does happen.

Third, he notes that even if they do invest they’re likely to do so at a lower price because you can’t truly get an independent valuation. He says that if somebody new looks at the deal they’re likely to call the seed investor and collude on a price that is artificially low. I’m sure this happens, too. But I’m also sure it doesn’t happen all of the time. As always it comes down to competition. If you have several new investors looking at your company you’re likely to get higher price.

2. Why are VC’s really doing seed deals? There are several reasons why VCs are doing seed investments. One of them is simply that more entrepreneurs don’t require as much money to get through their first milestones. When I was first starting companies in the late nineties it took $3 million just to get version one of our product out the door. We had to buy expensive Sun servers, Oracle databases, Unix licenses and build complex software. Bandwidth and hosting charges were expensive. These days solid entrepreneurs can get their companies through the first 12-18 months for $500-$750k. So if a VC wants to work with really talented early-stage entrepreneurs there are times where they have to be willing to seed fund them in order to be in the deal.

This was the exact case on my first two seed deals (and as a $200 million fund I fall into Chris’s “big” status – although I certainly don’t feel that way ). My very first seed deal was a company that told me flat out that they didn’t want to raise more than $500k. We offered them more : $750k-1 million. They said that they didn’t want the extra money or dilution. We took the $500k. We used the Y Combinator open source term sheet. We signed the term sheet within 48 hours and had funded in under 2 weeks.

How did it go so quickly? I knew the team for 2 years and had tracked their company through to pre-launch. We funded it just before they took the wrappers off of the company. They were grateful for the extra money as their launch was overwhelmingly successful and they had to rapidly hire staff to support customer demand.

It’s true that some VCs view seed deals as options. I do not. I’m not the only VC who feels this way. The deal I described has gotten just as much attention from me as the A round investments I’ve done because I haven’t done 15-20 seed deals – I’ve done three. The seed nature to me are just the size, price and risk factors – not a pure “option” to see what happens.

3. Signaling problems always exist - What Chris doesn’t make clear is that signaling problems exist with nearly EVERY investor. If you raise angel money that’s another story. But if you raise from any fund and unless the fund has a 100% consistent policy that they will absolutely never do a follow on investment then a signaling problem exists.

Let me give you an example. A very well known early stage fund used to have a rule that they didn’t do “follow on” investments. Life seemed easy as they told all investors that their model was to lead the first round and not to follow on. The problem is that all investors speak with each other. And I learned through the grapevine that they had done a very small number of follow-ons for their most promising investments. They didn’t announce that – it just happened. So once I knew this my obvious question on the deals that I looked at was, “ok, are you investing?” You can’t avoid it – signals always exist unless a fund is 100% absolute in its rules.

Or … you raised your $500k from angels and now are ready for a VC “A” round. You’re trying to raise $3 million at a $6-7 million pre-money (e.g. “A” investors will own 30-33% of your company). Well, if you raise that VC money you’ll have the signaling problem if they fall out of love with your company in the future because you’re not performing well. The reality of raising venture capital is that you’ll always have some signaling risk- frankly, there’s almost no way around it. It’s an occupational hazard. Your best antidote to the signaling effect, I’m afraid, is to perform reasonably well.

Let me give you another example. Let’s say you’re an EIR (entrepreneur in residence) at a VC firm. You were there for 9 months and then you left and created a company 15 months after you left. If that VC doesn’t invest people will ask why. That’s signaling. You’ll have your reasons and some VCs will get beyond that. But it’s a signal nonetheless.

Different scenario: You’re on your second company. A prominent VC funded your first company but isn’t currently investing in this company. Think that’s not a signal? Think again.

Or you’ve never done a startup but your last boss from Google, Facebook or Yahoo! is now a VC. Many are. They didn’t invest in your company? Signal, signal, signal.

OK, so your boss didn’t become a VC. You were a VP at a startup company that sold for $100-200 million making the founder very wealthy. You’re startup raised angel money and is now looking for VC. That founder wasn’t one of your angels. Think that the VCs looking at your deal won’t wonder why? Think they won’t call him? Signal.

It’s very hard to completely get around the signaling problem. It always exists. I agree with Chris that it is more prominent when a big VC invests in the seed round of your current company and doesn’t follow the investment. But if you raise money from a small seed fund and they don’t want to follow (and you’re not able to immediately raise new money) you’re equally screwed.

Brad Feld at Foundry Group also invests in seed deals (this is a great post worth reading on Brad’s views of seed deals). In fact, 7 out of Foundry’s first 16 investments were seed deals. Foundry is both stage agnostic and syndication agnostic. They don’t mind being the lead investor on deals that they seeded. How many entrepreneurs wouldn’t kill to have Brad and/or Foundry in general involved with their company.

First Round Capital meets Chris’s definition of a “big fund” and they do seed and A round investments. They also do follow ons so Chris’s point about signaling exists with FRC as it does with most investors. I’ve never met a FRC CEO has has anything but positive things to say about the fund and their involvement with portfolio companies. Sometimes they’re “over the top” effusive about FRC! FRC is the most innovative VC out there now. They’ve found a way to get leverage for their high volume of investments by running CEO Summits and special industry events beyond what many VCs provide with their lower volume of investments.

Same with True Ventures. Their entrepreneurs are evangelical about how great it is to be part of True’s portfolio. Big fund. Great reputation. Seeds deals. Would you not take money from them? I would. In fact, I nearly did at my second company but we were bought by Salesforce before we raised our round. True was my top pick to work with in Silicon Valley. They seemed to have a different way of working than most VCs, which I found appealing. And I know that True has done some very small seed deals as well as some larger A round deals. They seem to be managing fine with both models.

And then there is my firm, GRP Partners. I’ve made 3 seed investments out 5 total investments over the past year. Two of the three were at the founders’ request. In one of the three instances the company is now raising more money. I proactively offered the CEO to fund the company without any other investors having to come into the deal to lead it. I gave him what I consider a very fair price. I then told him, verbatim, “I feel this is a fair price. You’re more than welcome to shop around on Sand Hill Road for as long as you want. I’ll take the whole round, half of the round or my prorata. If you shop it be aware of a few things: 1) your information will be widespread in Silicon Valley including amongst your competitors (this is just a reality) and 2) it’s likely to take 6-8 weeks to get through the process if you’re doing well. If you accept my terms you’re done. Cash in bank in 30 days. Your choice.”

It wasn’t an easy decision for the team. It was sincere in my offer. They elected to sign my term sheet. Chris might say that they could have gotten a higher price had they shopped it. He might be right – we’ll never know. But the highest price possible is not always the best outcome for the company. I gave them a “high” price by Chris’s definition in his post on not taking seed money from VC, but I didn’t give them a “Foursquare Price.” But importantly, there was no signaling effect. By offering to take half the round or my prorata I fully enabled the company to do whatever they needed to do.

Entrepreneurs – please take note. I know you’ve all read Chris’s post because so many of you have told me so. He makes many great points so if you haven’t read it you should. But the reality is that in life it’s far more important to look at the whole picture. Make sure you know the reputation of the people you’ll be working with. I’ve covered that topic in this post on how to reference check your VC. If they blog make sure to read what they think because they make much of it known in writing. I’ve made my entrepreneur thesis clear.

It’s not black-and-white. It’s more important to pick wisely with whom you work at an early stage. Whom you work with is more important in my opinion than it is whether they’re a seed fund or a VC fund.

4. The plus side of good VC’s doing your seed round - I just want to hit one last topic that is worth noting. There is one point that Chris leaves out of his post. There can actually be a positive side of a “good VC” doing your seed round. I like to talk about seed investments with entrepreneurs in these terms:

a – if your company sucks wind don’t think that you’re guaranteed to get a follow on from me or from anyone else. if you completely miss the target you’re dead no matter whom you raise the money from. So a good VC fund or seed fund or angels in this case is all neutral. You’re forked either way.

b – if your business is “killing it” (e.g. doing really well) then it also won’t matter. Do you think companies like FourSquare or Gowalla would ever struggle to raise follow on rounds if their early stage VC’s don’t follow? Or for that matter can you imagine their VC’s not following? If you’re doing well you’ll have demand

c – so for me the most telling case is when you’re doing “ok” but you haven’t hit major proof points yet. This is actually what happens the majority of the time at startups so if it’s you, you’re in the norm.

In the “c” case (50%+ of outcomes) let me point out the following. It’s far easier to get an extra $500k out of a $200 million VC fund to get to your next milestone than it is to squeeze $500k out of 5 angels if they’re not sure you’re performing well. They often judge your performance on whether VCs show interest. How’s that for a dilemma?

And more to the point – if you hit a major economic down cycle (like September 2008) you’ll have tough times with all investors. But it will be much easier to get a small bridge from a VC than one from angels. Why? Because angels will have their money in real estate, the stock market, etc. and a VC’s fund has one purpose – startups.

And the final argument I hear is, “I’ll just do angel money now so I can shop my next round to a big VC at a high price.” Um … that’s fine in scenario “b” above. In scenario “c” – good luck. I’d much rather have the fund on the inside and on my team with the ability to bridge me than on the outside.

I am a fan of raising angel money and often tell entrepreneurs to do so. What I like most is that if your company has an opportunity for an early exit most angels would be delighted. I’ve written about the fact that I feel most businesses should never raise VC.

But if you plan to try and build a big company then involving good VC’s early can be a benefit. I think you’ll be just fine taking their money in your seed round and if it’s a small round I don’t believe most good VCs would block an early exit.

And for reference, most “good VC’s” will work with seed funds and angels in seed deals. In my first deal we took angel money in the seed round (from 2 angels) and an early-stage co-investor in the A round. In my second seed deal I did the whole round for expediency. In my third seed deal we co-invested with a seed fund and then syndicated the rest to strategic angels.

And if I ever got the chance to work with Chris Dixon’s fund I’d be delighted. I like the way he thinks.

that's not true Nivi. we are 10% holders in a company we seeded last fall but have not announced. they could go out and raise a follow-on round and they might. i want to own more so i offered them a pre-emptive offer that is likely higher than market. i can afford it because we already own 10% of the business. our average price will be lower than any new investor.

http://avc.com fredwilson

totally entrepreneur mythology. VCs are bad guys too.

http://avc.com fredwilson

it's a lot like a marriage. many end in divorce. so pick your partner wisely

http://avc.com fredwilson

enlightened self service

http://avc.com fredwilson

this is a great discussion chris. we solve the problem by doing the next round in almost every situation (every one to date btw). we sometimes have to hold our nose and write the check. and we signal by the amount of the check. but if you get one round from us, you are almost certain to get another round. it might be a bridge or two or it might be a small insider round, but you'll likely get another round.

we do that as an investment in our reputation. we know the money is not likely to generate our target return but its an investment in our franchise. treating entrepreneurs like options is a good way to self select yourself out of the best deals, so its a smart investment in my opinion

http://avc.com fredwilson

we've asked into several angel rounds, etsy is the one i can talk about but you are aware of another chris. i am pretty sure the entrepreneur has not regretted it in any of these situations. so i think this discussion is really about the quality of the firm you do business with not signaling.

Roman Giverts

Good story! I've never understood the herd mentality of VCs. Of all the people in this world, you would think VCs, especially former entrepreneurs, would be the opposite.

http://avc.com fredwilson

sadly most VCs are herd followers. but not the best ones. sequoia, benchmark, etc can make up their own minds, and do

Roman Giverts

Yep that's why they're in such high demand. As an entrepreneur I'm thinking how do I innovate and not follow the herd! How can a bunch of herd followers be the ones who are suppsosed to fund innovation. Just doesn't make sense

http://www.cdixon.org chris dixon

I agree. You are doing fairly large seed rounds (500-1M i think?) with the intention of increasing % ownership in most cases versus other firms who are putting in $50K for a pure option. Some of those are thought to be high quality firms. I don't think they are high quality but I it's a combination of firm quality and just how good the investor's intentions are.

http://portal.eqentia.com William Mougayar

Wow, that was the best VC sausage-making view I've read for a while. I love it how you guys agree but also disagree. As an entrepreneur about to go through a Series A ringer, it's telling me that venture capital is perhaps more art than science.

philsugar

I think its like marriage but without divorce…

philsugar

Call me conservative but I've always thought you should raise enough money that you're certain you can get to ramen profitable (Paul Graham's term).

So I think your point 4a,b,c is spot on.

If you're doing ok, everything is a signal. That's the whole point. Everybody is going to try to read the tea leaves on what the outcome will be….but not getting an investment shouldn't be something that puts you out of business.

I completely take Fred at his word, but I'm really surprised he would hold his nose and invest. If you're stinking it up you would know it and I can't see how you could be upset an investor turned you down for even more money.

dereklicciardi

Don't think I've ever thought about a follow on investment like that. Funny thing is that I dollar cost average all the time with my retirement savings. Thanks for pointing that out.

http://caterpillarcowboy.com dlifson

When I was raising my angel round at SXSW ( http://bit.ly/adeyBK for the full story), I met up with a VC from a large well known SV fund. He asked if I would be interested in having his fund fill in the last $50k of our round. For all the reasons stated above, I declined. We were oversubscribed anyway and had great angels – why take the risk?

http://www.linkedin.com/in/rajatsuri rajatsuri

The $50K option is surprising, most VCs I know put in several hundred thousand into their seed rounds. For example, most seed programs in VC have $250K listed.

Is that a personal sum, or from the fund itself?

http://www.cdixon.org chris dixon

Yep- best signs they are looking for an option is lack of diligence and small ceck size relative to fund.

http://www.cdixon.org chris dixon

From the fund.

http://portal.eqentia.com William Mougayar

Wow, that was the best VC sausage-making view I've read for a while. I love it how you guys agree but also disagree. As an entrepreneur about to go through a Series A ringer, it's telling me that venture capital is perhaps more art than science.

http://portal.eqentia.com William Mougayar

Wow, that was the best VC sausage-making view I've read for a while. I love it how you guys agree but also disagree. As an entrepreneur about to go through a Series A ringer, it's telling me that venture capital is perhaps more art than science.

philsugar

I think its like marriage but without divorce…

philsugar

I think its like marriage but without divorce…

philsugar

Call me conservative but I've always thought you should raise enough money that you're certain you can get to ramen profitable (Paul Graham's term).

So I think your point 4a,b,c is spot on.

If you're doing ok, everything is a signal. That's the whole point. Everybody is going to try to read the tea leaves on what the outcome will be….but not getting an investment shouldn't be something that puts you out of business.

I completely take Fred at his word, but I'm really surprised he would hold his nose and invest. If you're stinking it up you would know it and I can't see how you could be upset an investor turned you down for even more money.

philsugar

Call me conservative but I've always thought you should raise enough money that you're certain you can get to ramen profitable (Paul Graham's term).

So I think your point 4a,b,c is spot on.

If you're doing ok, everything is a signal. That's the whole point. Everybody is going to try to read the tea leaves on what the outcome will be….but not getting an investment shouldn't be something that puts you out of business.

I completely take Fred at his word, but I'm really surprised he would hold his nose and invest. If you're stinking it up you would know it and I can't see how you could be upset an investor turned you down for even more money.

dereklicciardi

Don't think I've ever thought about a follow on investment like that. Funny thing is that I dollar cost average all the time with my retirement savings. Thanks for pointing that out.

dereklicciardi

Don't think I've ever thought about a follow on investment like that. Funny thing is that I dollar cost average all the time with my retirement savings. Thanks for pointing that out.

http://caterpillarcowboy.com dlifson

When I was raising my angel round at SXSW ( http://bit.ly/adeyBK for the full story), I met up with a VC from a large well known SV fund. He asked if I would be interested in having his fund fill in the last $50k of our round. For all the reasons stated above, I declined. We were oversubscribed anyway and had great angels – why take the risk?

http://caterpillarcowboy.com dlifson

When I was raising my angel round at SXSW ( http://bit.ly/adeyBK for the full story), I met up with a VC from a large well known SV fund. He asked if I would be interested in having his fund fill in the last $50k of our round. For all the reasons stated above, I declined. We were oversubscribed anyway and had great angels – why take the risk?

http://www.linkedin.com/in/rajatsuri rajatsuri

The $50K option is surprising, most VCs I know put in several hundred thousand into their seed rounds. For example, most seed programs in VC have $250K listed.

Is that a personal sum, or from the fund itself?

http://www.linkedin.com/in/rajatsuri rajatsuri

The $50K option is surprising, most VCs I know put in several hundred thousand into their seed rounds. For example, most seed programs in VC have $250K listed.

Is that a personal sum, or from the fund itself?

http://www.cdixon.org chris dixon

Yep- best signs they are looking for an option is lack of diligence and small ceck size relative to fund.

http://www.cdixon.org chris dixon

Yep- best signs they are looking for an option is lack of diligence and small ceck size relative to fund.

http://www.cdixon.org chris dixon

From the fund.

http://www.cdixon.org chris dixon

From the fund.

http://richineverysense.blogspot.com/ scheng1

I think from the standpoint of entreprenuers, signalling risk is hard to overcome. It is very hard to change the mindset of people when they have formed a bad impression due to bias.

http://richineverysense.blogspot.com/ scheng1

I think from the standpoint of entreprenuers, signalling risk is hard to overcome. It is very hard to change the mindset of people when they have formed a bad impression due to bias.

http://nabeel.typepad.com nabeel

In the marriage analogy, sometimes both people need someone new to see them in a new light. As much as entrepreneurs and VCs talk about “accepting failure” as part of the path there are very few who actually don't hold it against folks.

Obviously George had a hard time seeing past Odeo. It is interesting that as a firm CRV has done several deals recently where they were backing entrepreneurs that haven't gotten amazing outcomes for them but who they trust will in the future (David Cancel, Evan Schumacher). They obviously just couldn't get there with Evan for whatever reason, but thankfully someone was there to see it with fresh eyes.

http://nabeel.typepad.com nabeel

In the marriage analogy, sometimes both people need someone new to see them in a new light. As much as entrepreneurs and VCs talk about “accepting failure” as part of the path there are very few who actually don't hold it against folks.

Obviously George had a hard time seeing past Odeo. It is interesting that as a firm CRV has done several deals recently where they were backing entrepreneurs that haven't gotten amazing outcomes for them but who they trust will in the future (David Cancel, Evan Schumacher). They obviously just couldn't get there with Evan for whatever reason, but thankfully someone was there to see it with fresh eyes.

http://avc.com fredwilson

i think it was also twitter

there are plenty of people who still think twitter is silly

http://avc.com fredwilson

i think it was also twitter

there are plenty of people who still think twitter is silly

X LP

Chris, there is no way anyone can logically argue that FRC does not do “option-based” investing.

Let's look at the facts:

They have close to 100 companies in their portfolio, a ratio of 25 companies per partner. There is no way they have adequate time to spend with the vast majority of these companies.

They have well over a $100 million fund and are likely to raise another soon. There will be massive signaling effects for any entrepreneur who raises money from them. This is compounded by the sheer number of companies in their portfolio, which don't allow the firm to add much or any value to their portfolio companies.

Finally, and most importantly, they position and market themselves as an option-based investor to LPs (I used to work at one of their former LPs and saw their PPM).

This is not meant as a personal attack on FRC (again I am only stating facts, not my personal opinion) . Given the number of portfolio companies, their fund size, and approach to investing, FRC is the poster child for option-based investing.

Mark is right that these types of firms have suffered some amount of reputation fall out. I've heard this from a number of sources over the past couple of months.

X LP

Chris, there is no way anyone can logically argue that FRC does not do “option-based” investing.

Let's look at the facts:

They have close to 100 companies in their portfolio, a ratio of 25 companies per partner. There is no way they have adequate time to spend with the vast majority of these companies.

They have well over a $100 million fund and are likely to raise another soon. There will be massive signaling effects for any entrepreneur who raises money from them. This is compounded by the sheer number of companies in their portfolio, which don't allow the firm to add much or any value to their portfolio companies.

Finally, and most importantly, they position and market themselves as an option-based investor to LPs (I used to work at one of their former LPs and saw their PPM).

This is not meant as a personal attack on FRC (again I am only stating facts, not my personal opinion) . Given the number of portfolio companies, their fund size, and approach to investing, FRC is the poster child for option-based investing.

Mark is right that these types of firms have suffered some amount of reputation fall out. I've heard this from a number of sources over the past couple of months.